ALL YOU EVER NEED TO KNOW ABOUT STOP LOSS PLACEMENT

Are Stops Necessary?

I imagine this is going to be my least popular article ever. It deals with stop-losses!!! Most people
prefer to read about entry techniques. No one likes to read about topics that has to do with losing
money.

If you are a typical retail home trader, you might think stop-losses are unnecessary, but no
professional trader with proper supervision will be able to trade without an exit strategy of some
sort. If you want to trade like a professional, you are forced to consider the possibility that you are
wrong about the trade. Your job depends on it.

Consequently, this article is not about why you should use a stop-loss. Rather it is about where you
should place the stop-loss.

What will you learn from reading this article?

1. Why professionals use stops

2. The use of Hard Stops

3. The use of Volatility Stops

4. Volatility Stop with a MACD intra-day technique

5. 2-Bar Stop

6. Aggressive Bar Stop

During a public speaking trip around Denmark I gave talks about trading and investing. I came face to
face with both traders and investors. I discovered that investors are lousy risk managers. They have
an attitude of invincibility. They think because they invest for the long-term, they don’t have to use
money management.

Up in Aalborg, I came across a particularly ignorant investor who said he didn’t need stop-losses. He
bought for the long-term. I asked him about his most recent purchase. He had bought shares in
Novo Nordisk at 310. It was now at 290. I asked him if he would keep if it fell to 270. He said he not
only would hold it, but he would buy more. What if it fell to 250? He said he would consider it cheap,
so he would probably add some more. What if it fell to 200? He said if it got to 200, he would get
out. That would have been too much for him.
Bottom line, the man DID have a stop-loss. He just wasn’t aware of it until he was facing a big loss. I
think it is fair to say that everybody has a stop - if they care to go through this mental exercise
before making a trade or an investment.

Put simply, I imagine that his stop loss could have been at a better place than at losing 33%, not to
mention his bad habit of adding to a losing trade.

This article is written with the view of exploring our options when we place a stop loss. I have added
a couple of trading techniques so you can get an appreciation for how important money
management is to a trading technique.

Before we dive into stops and techniques, I need to do something. I hate to do it, but no trading
article is complete without it: A risk warning – or 4 of them:

1/ Stops don’t come naturally – so you must train yourself to use them

Everyone is aware that placing a stop-loss is like admitting the possibility that they could be wrong.
As no one knowingly goes into a position with the thought they might be wrong, placing a stop-loss
is not a natural action. However, if you learn to place your stop-losses well, you might end up
enjoying the process. At least consider it as natural and as necessary as the surgeon washing their
hands before operating on you.

2/ Your capital is your life blood – a stop loss keeps you alive

I seem to have taken a step into the medical metaphors so why not stay there for a moment. Your
trading capital is your life blood. If you don’t protect it, you will die. All stops do is to protect you.
Yes, they may also annoy you or frustrate you, but they are there to protect you.

3/ DO place stops when you are thinking straight

DO place stop-loss when you are thinking straight – not when you are under stress due to the
position losing you money. It is hard to think clearly when you are about to be hurt or already
hurting.

4/ DO NOT move the stop-loss further away - EVER

Stops are a one-way street. When you are long you can only raise the stop. When you are short you
can only lower it. We all know how frustrating it is to have our stop-losses taken out, and then see
the market move back in our favour. However, that is not an argument for not having stop-losses or
for moving a stop further away, in order to give the trade “a bit more room”.

That’s it. Preaching is over. So let’s focus our attention on learning how to place good stops.
Stop losses amongst professionals?

Do all market professionals use stop losses? NO.

There are many segments within the trading and investment community that do not use stop-losses.
Hedgers don’t use stops. They sell out future inventory. Option traders may use options as a hedge
(stop loss) against a position.

The market is often like a chess game for big traders. They don’t want to tip their hands. If they put a
stop-loss in the market on a big position, it is like a red cloth to a bull. The market will seek to move
to where there is liquidity. If there is a big order resting somewhere, the market may see this and be
drawn towards it.

Big traders may not place stops. We are talking BIG here, probably not people like you and me.
These iron-willed professionals will have mental stops but probably not physical stops. They don’t
want the market to know where their stops are, nor do they want their broker to know (remember a
broker makes money from executing trades, so it will be in his interest that the client is stopped
out).

When their levels are touched they will take their loss without remorse or second thoughts. Taking
losses is part of the process of making profits.

Placing a stop loss is a challenge. We want to place a stop close enough to protect your capital but
not so close that it is sucked up in the „noise‟ of the market. What is “noise” I hear you ask? Noise
may mean different things to different people, but to me “noise” refers to the subtle back-and-forth
movements in the market which don’t change the trend.

Chart 1: DAX
The DAX (chart 1) trend looks negative, but within the two black lines the market is oscillating
around 30 points up and down – without changing the trend or continuing the downward trend. I
define this as noise.

However, you can’t ignore noise as if to say it doesn’t matter. I was short the DAX in this example,
and I defined the noise as the trading range between 12740 and 12710. Therefore, I placed my stop-
loss outside the noise. Soon after this screenshot was taken, the market jumped to 12800. I was
annoyed my trading idea didn’t work out. I was happy I had a stop loss.

Noise means different things to different people. Short term traders see backing and filling activity
as noise. Some call it the ebb and flow of orders and business being executed – essentially, it has no
meaning and it does not change the direction of the market.

For long-term investors and position traders, the daily volatility is just noise in the current bull run
and they may not pay close attention to it. They know not to get sucked into the emotional fray of
short-term movements if they want to secure big profits. Noise could be measured in percent in
their world. It is all a matter of perspective.

Stop Loss Techniques

Let’s look at a number of techniques suited to short-term trading. I am a short-term trader and so
are you likely to be. Short term here means day trading and also keeping trades for a few days - but
rarely longer than a couple of weeks.

Hard Stop

A Hard Stop is one in which you place a stop a certain number of pips or points or percent from your
entry price. As an example, you would always use a 12-point stop loss in DAX or a 25-point stop loss
in Sterling Dollar.

This stop-loss doesn’t make much sense, because it assumes the market is always in the same state
of volatility. It sure as heck isn’t. I have seen the Dow Jones index trade in a 20-point range all day –
the day before Xmas. I have seen the Dow Jones jump in 50 point increments – the day Lehman
Brothers went bust.

Why would you place the same 12-pip stop in both a quiet market and one showing volatile market
conditions? Similarly, why would you risk the same 25 pips in both quiet and volatile market
conditions? A stop set in this manner is not related to the market in any way.

Despite its obvious flaws this technique is one of the most commonly used methods for placing a
stop-loss. This is also the preferred method for professionals and their risk managers. When I traded
for a company, I was told I could not lose more than 50 points. As long as my losses were 50 points
or less I was fine. The end result was that I always risked 50 points, even though my stop loss could
have been far less.
A trader friend recalls a story from his days trading at a prop desk. “We had a risk manager who let
us get away with murder – as long as our losses were less than 35 points. It was insane because we
could lose 35 points and then put on the same trade again – again with a 35-point stop loss. Even
when we needed a much smaller stop-loss, we would still use a 35-point stop, because it gave our
position much more leeway. The problem was that whenever we lost, we always lost 35 points.”

I don’t think hard stops should be used. They don’t make any sense.

Volatility Stops

Volatility is a two-edged sword for traders, but I often remind myself that as traders we live by the
sword and we die by the sword. I have a craving for volatility and at the same time I hate volatility.

For example, I have lost track of the number of times I bought into a signal during the morning hours
in the DAX, and built up an acceptable position, only to see my stops hit because the US markets
open, with volatility cranked up 100% for 30 minutes or so.

As a short-term trader, I like the mix of quiet and volatile markets. Volatility is often associated with
losses and is often blamed for them. For a day trader, this is not true. Yes, higher volatility does
mean higher risk as a direct result of higher fluctuations in the price. However, while it is concern for
some, we do need volatility to make money as short-term traders. Really, volatility is a degree of
uncertainty. Without volatility, there is no opportunity for short-term profit.

The Volatility Stop technique adapts to the market. It dynamically self-adjusts. As such it is a much
smarter way of placing a stop-loss than the “hard stop”.

Under the heading of “Volatility Stops” I’ll describe which tools are available.

There are a number of ways to measure volatility but a simple technique uses the Average True
Range (ATR). This was developed by Welles Wilder. All charting packages will have this function.

Volatility Stop Method 1: A trading technique with a volatility stop loss

ATR is a measure of the underlying volatility of an instrument. If the Daily ATR is 100 over a 14-
period setting, then it tells me the average High minus Low is 100 points. Can I use this for anything
as a day trader, who trades a 5-min chart? I believe I can.

On the FTSE chart below I have established that the daily ATR is about 55 points. In other words, the
average High minus Low is 55 points over the last 14 trading days. The 55 points represents a daily
volatility average.
I will introduce a simple trading technique in the FTSE index by way of example. The MACD is a
simple tool for timing your trading entry. I am not advocating MACD (I am not saying no to MACD
either), and I am not going to tell you what techniques to use or not to use. I personally find MACD a
little slow, but many people swear by it.

Remember – it is an M Average CD, so there will be a delay in the signal, but for the sake of the
example, I think you will appreciate its efficiency, and it happens to be profitable!

The idea of a MACD system is to buy or sell short based on the crossover of the lines. The ATR
calculations will guide us to how big the stop loss must be and what our target calculation can look
like.

I will use a 20% ATR stop – meaning my stop loss is 20% of 55 points, i.e. 11 points. If I risk 11 points
per trade, I will want to use a 150% profit target, meaning I will want to make 16.5 points.

If I get a MACD counter signal and I am still long/short with a profit, I will move stop loss to
breakeven, or I will take a loss without waiting for the stop to be hit if the position is losing.

I use a standard generic MACD with a 12-26-9 setting.

I am trading the FTSE 100 index, using a 2min time frame.

Entry Time Price Profit/Loss?

08:32 7413 0

09:42 7413 minus 7

09:52 7419 plus 4

10:42 7423 plus 16.5

11:34 7402 plus 16.5

13:34 7424 minus 7

13:56 7430 minus 4

14:02 7426 plus 16.5

14:54 7415 plus 16.5

15:54 7435 plus 4 (note – closed the position as market closed)

26th June 2017

Was I just lucky on the 23rd? Let’s see:

Entry Time Price Profit/Loss

08:22 7464 minus 4

08:52 7466 minus 11

09:18 7467 minus 4

09:36 7465 minus 1

09:50 7466 Plus 16.5

FTSE then went into a 5-point trading range for the next 110 2-min bars. This is where an element of
skill and knowledge will save you from being whipsawed from short to long and back.

15:36 7468 plus 16.5

16:14 7448 plus 5

The initial stop was 11 points, but if I got a counter-signal, as I did on the 26th at 08:52, I would close
the position and take the signal in the opposite direction. Hence the loss is minus 4. As you can see,
it would have been a better option to have left the position alone, as the position I closed would
have been profitable, and the one I opened at 08:52 was a loser.

All in all the system has delivered a result which suggest it is worth pursuing. The problem with
MACD is that it is a lagging indicator. Another problem is that you don’t know for sure that a MACD
crossover has taken place until the bar has ended. More experienced traders could probably get
better entries than I have (although I doubt it – these things tend to even themselves out over time).
Here I have waited for the actual bar to close to confirm the MACD signal. Yet a third problem can
arise during a quiet morning, when there are multiple crossovers, leading to overtrading, as a result
of a sideways market.

The stop-loss ratio and the profit worked exceedingly well – although it was a very limited sample to
the point of being meaningless. Nevertheless, I hope this has given you appetite for doing your own
research – or want to continue where I have left of.

What ATR does for Swing Traders and Day Traders

The 55-point average daily range in the FTSE has 2 possible uses for me.

If I am trying to stay out of the noise for the sake of trading the market short-term (on say a 1-min or
5-min chart), I will use a stop loss of 20% of the daily ATR. At the moment, this means running stops
in the DAX intra-day at around 24 points, while in the FTSE I run stops around 11 points.
You must appreciate that we are talking short-term trading – with intense screen watching. I am not
sure most people can stomach a 24-point stop loss in the DAX, unless they frequently get 36 points
or more in profit?!

I used to be ok with trading the DAX with a 12-point stop loss. That was when the DAX was trading at
8000. Now it is trading at 12700. The ATR forces you to adjust your stops over time as your products
increase in absolute price.

If my desire is to run a swing trade lasting more than one trading session, then I need to entertain
the idea of having a stop loss of more than 50% of the daily ATR. This means using a stop loss of 28
points in the FTSE at this point in time.

I admit that there is an arbitrary element at play here. Why 20%? Why 50%? The fact of the matter is
that I need to weigh the desire for good money management with the time expended doing the
research. I make my money by having positions on. The research is my road map for my action in the
market, but I can’t be all “research” and no trade. These two percentages have worked well for me
for a long period of time.

I write this, not to make excuses or deflate myself, but to make sure you know you are free to inject
your own taste and style into my suggestions (I am stating the obvious - I know you will anyway).

Currently Sterling Dollar is trading at 1.2700. The Daily ATR is 90. A variation of the volatility stop is
to use 10% on markets where the spread is lower and the volatility is lower. 10% stop is 9 points loss
with a 13.5 profit.

26th June 2017

Entry Time Price Profit/Loss?

07:10 1.2745 plus 13.5

09:00 1.2744 plus 13.5

11:20 1.2734 minus 9

15:20 1.2728 minus 9

26th June 2017 (again – but with a 20% volatility stop – risk 18 to make 27)

Entry Time Price Profit/Loss?

07:10 1.2745 0 (moved stop loss up when position more than 10 in plus)

09:00 1.2744 plus 27

11:20 1.2734 0 (moved stop loss up when position more than 10 in plus)

15:20 1.2728 plus 10 (close position at market when trading day over)
The market has a “human volume” rhythm which means you need to appreciate that volatility is not
uniform throughout the 24-hour time period. For example, FX traders in London are ready to work
around 7am. Until then the market is dead. The green shaded area should give you all the evidence
you need to understand that nothing is going on.
Some mornings the market is screaming its head off. Other mornings the market is merely limply
whispering its message. I will adjust my stop accordingly.

Volatility Stop Method II

I am currently short Dollar Yen. I am doing my best to stay with the position – balancing the trade-off
between giving the position “space” but not too much space.

A simple method centres around the size of the counter-trend moves. Dollar Yen is trending down,
but there are counter moves where traders are taking profits or commercials find the current price
attractive.

I am trying not to get stopped out in the counter moves because I am hoping they are temporary
moves against the dominating trend.

The art of drawing a line on your chart of the size of the corrections gives you an idea of how much
past corrections have amounted to. In a strong or a medium strong trend, corrections tend to be
similar.

Today I am attempting to roll my stop so it is constantly about 15 points away from the current
market price (but never moving the stop higher – of course. The last corrections have been about 9-
12 points in size.
This is a Dynamic Stop - a clever stop loss technique and a very potent tool for short-term traders
because it adjusts to the market rhythm. Traders well traversed in the art of geometry trading would
say that any correction above 12 points will “over-balance” the structure of the chart, and the
market is telling you that it is now in a different degree of wave. It sounds quite Elliotastic, don’t you
think?

2-Bar stop loss

The 2-bar stop loss is simple to explain. Imagine you are long the market. You look at the current bar
and you compare it to the 2 bars that came before. Your stop loss should be just above the high of
the two previous bars.
If the current bar closes, and you can see that the new 2-bar high is actually the bar that came just
before the one which just closed, then you can move the stop loss down just above the high of that
bar.

How does it work? Let’s take another practical example, and demonstrate yet another trading
technique. This way you will develop an appreciation for how close stop-losses can actually be.

There are many trading techniques which are good at generating very timely signals. The Stochastic
generate frequent trades. The good ones move fast in your favour but they tend to not last long.

We need to work a tight form of exit control, otherwise we will not be profitable. We must accept
that Oscillators are often wrong. We have to budget for that and keep losses small because they will
be frequent.

Here we have a 5-minute chart of Crude oil. I have used a Stochastic method. I review the stop-loss
after each 5-min bar. I will keep trailing the stop-loss up (for the long position) and review every 5-
min. If the next bar is an inside bar - meaning the low is higher than the previous bar, and the high is
lower than the previous bar - then I do nothing.

Here I am trading US Light Crude. The signals are below

Time Price Signal Risk Exit Time Exit Price

13:55 43.26 Short exit above 43.34 14:45 43.14

When I asked for feedback from a friend of mine on this chapter, she said she didn’t think I had
explained the 2-Bar stop very well. I hope the following will rectify that.
Marubozu Stop

A Marubozu bar is the technical term for what I call an Extended Bar or a Road Map Bar - or even an
Aggressive Bar.

It is basically a bar which tends to be longer than the preceding bars, but its most important feature
is that it has no head or tail (or sometimes neither). Some call them Hit And Run bars.

It is a powerful candlestick pattern.

If it happens against the trend, it is a reversal pattern like a „key reversal‟. In the direction of the
trend it marks extreme conviction. So if you are long and get a Marubozu, the conviction is strong
that it will continue. The market has put on a spring.

Often this leaves even our aggressive stops uselessly far behind. We cannot allow a reversal of that
size before cutting the position. That would leave a lot of open profit unsecured.

The trick is to use the mid-point of the Marubozu as the stop loss (or slightly above the mid-point).
Normally if the confidence is high the half way point is enough cover for you.

Indicator Stops

The idea is to make the market show you a sign of weakness (or strength, if short) before you get
out. You are less likely to get shaken out of a trade. This method makes more sense than trying to
pick a top to exit your long, or a bottom to exit your short. We need very sensitive indicators for this.

Anything slow (moving average based) will be too late giving us the message. In my opinion the best
indicators to use for a stop trigger are indexed indicators such as RSI, Williams%R, Stochastics or the
Commodity Channel Index.
Earlier, we saw an example of the Stochastic giving a Sell signal. I got the exit signal before the 2-bar
stop was activated so at least in this case it is confirmed that using indexed indicators provides faster
entries/exits. As always, there are two sides to the coin and we may also be taken out of the trade
prematurely.

Summary

Having discussed various methods for stop-loss placement, we can draw a few conclusions. First,
never use Hard Stops as they don’t take into consideration the prevalent market conditions, nor the
special characteristics of the market you trade.

The other methods available all have their strengths and weaknesses, and you need to determine for
yourself which one will suit your personal trading style the best. If you operate on very short time
frames, you most likely would prefer a different technique than if you are more of a Swing Trader.

Also, it is important to adjust your stop-loss methodology to the markets you trade. But don’t fret
about it, because remember there’s no single, right way to do it. Experiment and be flexible - but
once you decide on a certain style don’t tinker with your stops. Respect them as they are key to
keeping you in the game!